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capital budgeting

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capital budgeting

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- SMEDA Feasibility Footwear Retail Outlet (Rs. 1.31 Million)
- New Heritage Doll
- Assignment - Capital Budgeting
- 9 Risk Analysis in Capital Budgeting
- 4. NPV vs IRR.ppt
- Solutions C07
- -Ppt-of-Capital-Budgeting
- capita budgeting-18-1-2011
- Notes on Chapter 5
- Finance management lecture presentations
- Investment Decision
- Bala's Material on Capital Budgeting
- Capital Budgeting
- deochutal
- Financial Management Naaz
- CH5.doc
- WK6.2 Project Financing Evaluation Pt1
- question answer
- Aurora Final
- Capital Investment

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David Duran

uncoordinated basic data are collected, sifted, organized, and subjected to various quantitative

techniques - all to produce a final appraisal stressing the considerations most important to a financial

manager responsible for selecting investment opportunities. Much current thinking favors concentration

to the limit, as in Teichrow, Robichek, and Montalbano [11]: "Since the decision problem under general

conditions is extremely complicated, much of the literature is concerned with simplifying the problem by

assigning to each project a single number which indicates a 'preference.'" Here is a prescription for

maximum simplicity achieved through maximum concentration; it is also a prescription for maximum

loss of information, since concentration is achieved by ignoring (or at least playing down) complexities

and sifting out all in- formation thought to be of less than primary impor- tance. At best, the reduction

of a complex problem to a single number indicating preference will result in a minimax - if the number

selected entails less loss of information than all competing single numbers. An obvious means of

reducing loss of information (cf. Durand [3, 4]) is to use two or more numbers to indicate preference -

striving for an economic trade-off between simplicity and comprehensiveness. Although defining and

then finding an optimal trade-off is vir- tually unthinkable, the extreme position of reducing all

complexities to a single number must be far from optimal. Indeed, an overall view of the literature indi-

cates that the combined efforts of individuals seeking a single number have failed to produce one satis-

factory to all users; instead, these efforts have produced a variety of numbers, and demonstrated their

usefulness in specific applications if not in general. By now, any investment analyst with open eyes will

see before him a virtual smorgasbord of analytical techniques and numbers indicating preference. This

paper takes a bird's-eye view of the possibilities of using multiple numbers to indicate preference -

including a view of the bond market, where multiple numbers are well understood. It starts with the use

of multiple numbers to analyze a single cash- flow series, then proceeds to the use of multiple cash- flow

series to represent a single investment. It closes with a brief comment on the trade-off between

simplicity and comprehensiveness.

Among bond analysts the use of multiple numbers to indicate preference is commonplace. At the least,

an analyst uses a combination of yield to maturity (YTM) and term to maturity (TTM) - the first as an

index of profitability, the second as an index of liquidity or of sensitivity to changing interest rates. But

these two may not suffice. Often the coupon rate is needed in one form or other - say in the use of

current yield by a trustee responsible for providing an elderly widow with income, or in the distinction

drawn by many analysts between deep discount bonds (low coupon) and low discount bonds (higher

coupons). Finally, the sophisticated portfolio manager may use duration (cf. [1, 4, 5, and 6]) as an

improved measure of sensitivity to changing interest rates; the calculation of duration requires three

parameters - e.g., YTM, TTM, and the coupon rate.

Outside the financial markets the use of multiple numbers is by no means unknown. In a recent survey

of capital budgeting practices, Gitman and Forrester [7] asked 268 companies to report (among other

things) both primary and secondary techniques, or numbers, actually used. Of the 110 respondents, 93

in- dicated a secondary technique, implying multiple numbers, and one or two even indicated more than

one primary technique. The most popular primary listing (60 replies) was the internal rate of return

(IRR), analogous (mathematically almost identical) to YTM for bonds. The most popular secondary listing

(41 replies) was the payout period (POP). Because the sur- vey provided no cross-classifications and no

details on how techniques were used, we cannot be sure how many of the respondents used the specific

combination of IRR and POP, or how they coordinated IRR and POP. Here is a tantalizing question,

because POP is subject to two interpretations - 1) as an index of profitability, for which it is inferior to

measures like IRR,' and 2) as a measure of liquidity, roughly analogous to TTM for bonds. These two

interpretations are often confused; indeed one of the few writers to recognize them was Weingartner

[12], who suggested using POP as a constraint to supplement some more appropriate measure of

profitability, say IRR. So, one wonders, how many of the respondents 1There is an important exception -

for cash-flow series where only POP is computable. If, say, an investment of $1,000 were expected to

bring in roughly constant returns of $525 a year for about three years and then declining returns for an

unpredictable number of years, POP would be easily computable (1.9 years), but not IRR. used IRR as a

measure of profitability and POP as a constraint - more or less as suggested by Wein- gartner?

Although IRR has support from both theoreticians and practitioners, it falls short of ideal; substitutes

have been avidly sought, although none has been found to satisfy everybody. Among the substitutes

proposed are present value (PV) and two refinements derived from it - net present value (NPV) and the

net benefit-cost ratio (NBC). Unlike IRR, none of these is uniquely defined by the cash-flow series; each

depends on the choice of a cost of capital, or discount rate, which must be estimated or selected

arbitrarily. Consider the illustrative investments A and B in Ex- hibit 1. Each consists of a lump-sum

outlay of $1,500 followed by a series of regular monthly repayments - 30 repayments of $75 for A and

80 repayments of $40 for B. From this information alone, one can calculate IRR, getting 2.84% per

month for A and 2.20% per month for B - unique values ranking A before B. For calculating PV (also NPV

and NBC), however, a dis- count factor is needed, and this requires either ad- ditional information on the

cost of capital, or a purely arbitrary assumption. Exhibit 1 includes PVs corre- sponding to an assumed

discount rate of 1%/month; the results are $1,936 for A and $2,196 for B - values ranking B before A, in

contrast to the ranking by IRR. But note, if 1.75% per month had been assumed for discounting, the PVs

would have been $1,739 for A and $1,715 for B - values reversing the previous ranking and confirming

the ranking by IRR.

The import of this example is that PV (also NPV and NBC) is no better than the available estimate of the

cost of capital. If the estimate is tenuous - as usual - so too must be the resulting PV. And when the cost

of capital is represented by a range of values to allow for uncertainty, PV must also be represented by a

range - thus hardly qualifying as a single number indicating preference. Even so, PV can provide valuable

insights and aids to judgment if used as a supplement to rather than substitute for IRR or perhaps to a

combination of IRR and POP. The es- sential advantage of PV is that it exploits available in- formation on

the cost of capital - information not used to calculate IRR and POP.

If PV (or NPV or NBC) is to be used effectively as a supplement to IRR, something needs to be known

about the functional relation between the variables. The general principle that investments ranking well

in terms of PV tend to be those with a long-term com- mitment and an IRR substantially higher than the

cost of capital is almost certainly well known; what is not so well known is the following specific

equation for the net benefit-cost ratio:

where d is the approximate amount by which IRR ex- ceeds the cost of capital, and T is a temporal

measure closely related to Boulding's [2] "time spread" and the actuaries' "equated time" (cf. Durand

[4]). (Deriva- tion and further explanation will be found in the mathematical appendix.) Note that the

approximate relation in the second line is reasonably good only when d and T are small; when d and T

are as great as for investment C in Exhibit 1, the approximation will be downright poor. To illustrate the

equation, Exhibit 1 includes values for NBC, d, T, and POP for the two investments A and B already

discussed, and for a third investment, C, especially constructed to appear extraordinary. Because C

combines a long-term commitment (100 months) with an extremely high IRR (114% annually with

compounding), PV and NBC are both high; POP, moreover, is low, being affected by the IRR but not by

the length of commitment. Note that T is shorter for C than for B (26.3 vs. 32.3 months), although B's

total commitment is shorter than C's (80 vs. 100); the reason is C's high IRR.

Although the tabulated numbers indicating pref- erence rank investment C a clear first, they leave

doubts about A and B, as already indicated. The rank- ing based on PV or NBC conflicts with that based

on IRR or POP. Some insight into this conflict can be gained by expressing NBC through the

approximation in formula (1), thus

For A: NBC ~ 1.83 X 14.1 = 0.26

For B: NBC - 1.19 X 32.3 = 0.38

The implication here is that the ranking based on NBC (or PV), with discounting at 1% per month, puts

more weight on the long time period T = 32.3 than on the high differential return d = 1.83. But should it?

Essentially, A has the advantage of rapid growth coupled with a relatively high return; B has the advan-

tage of locking in a lesser but still good return for a much longer period. The problem then is to evaluate

the trade-off between these advantages; there is no easy solution, but additional insights will be offered

in the next section.

When simplicity is the goal of investment analysis, any one investment can be reduced to a single cash-

flow series by strong-arm methods - by making enough simplifying assumptions and ignoring all in-

formation that does not conform to a convenient pattern. When comprehensiveness is the goal, how-

ever, many an investment can be far better repre- sented by a multiplicity of cash-flow series than by

any one alone. Multiple cash-flow series result from alternative assumptions concerning performance.

For a clear-cut example, consider an issue of callable bonds - say, New Jersey Bell Telephone 145/8%

debentures of 1 March 2021, which are callable as a whole or in part on or after 1 March 1986 at prices

beginning at 111.51 and declining stepwise to par on 1 March 2017. Al- though these are rated triple-A,

their future perform- ance is by no means certain. The actual cash-flow series may terminate at maturity

with a payment at par plus interest, or much earlier with a payment at the call price plus interest. To

allow for this uncertain- ty, a curious bond buyer can investigate cash-flow series corresponding to

various assumptions concerning call - say, call at the earliest date, and then at some intermediate date;

then for each such series he can calculate a yield to call, arriving at one or more alternatives to the

standard yield to maturity. For further analysis, see Homer and Leibowitz [9, pp. 58-64, 163-167].

For investments in plant and equipment, the cash- flow series consists not of contractual payments, as

with bonds, but of estimates and forecasts by engineers, accountants, and other experts; it is thus even

more uncertain than a series for bonds, and depends critically on assumptions concerning physical

efficiency, service life, obsolescence, future prices, allocations of cost, competition, and much more. For

each possible set of assumptions there will be a different cash-flow series, each with its own IRR, POP, or

NBC. To limit the analysis to just one of these series - even if it corresponds to assumptions thought

most probable - is to ignore much relevant information and to sacrifice valuable insight. The alternative,

of course, is not to analyze all conceivable series, an impossible task leading only to confusion, but to

compromise on a manageable set of series judiciously selected to cover a spectrum of contingen- cies

broad enough to give the responsible financial manager an adequate appreciation of the more ob- vious

risks and uncertainties associated with the in- vestment projects under consideration.

Multiple cash-flow series may also serve to in- vestigate alternative assumptions concerning the

reinvestment of repayments - a matter of particular appeal to investors whose goal is accumulation

rather than income; examples include the company wishing to expand by ploughing back earnings, or

the manager of a pension fund during an initial period of rapid growth when there will be contributions

and security income to invest, but no benefits to pay out.2 A procedure for analyzing accumulation

quantitatively starts with the more or less arbitrary assumption of an accumulation period and of a rate

of return for the reinvested repayments over this period. Exhibit 2 gives accumulated amounts after 80

months for the invest- ments A, B, and C of Exhibit 1 when repayments are reinvested to earn stated

rates (1% to 1.75%) for the remainder of the 80 months. These accumulated amounts were obtained by

assuming, in effect, that each repayment would be deposited in a hypothetical savings account to earn

interest at the stated rate. Computations are reasonably easy with a hand-held business calculator or a

table of compound interest functions.

The essence of this analysis is the conversion of an original cash-flow series into a new and somewhat

ar- tificial series. For investment A, the original series consists of 30 monthly repayments of $75

following the original outlay of $1,500; the converted series con- sists of a single repayment (amount

depending on the assumed rate) at 80 months after the outlay. Other forms of conversion are possible -

say a split of monthly payments between current income and ac- cumulation. If the $40 repayments for

investment B were split evenly, say, the converted series would con- sist of $20 per month income for

79 months and a final payment consisting of $20 plus accumulation equal to half the tabulated amount

in Exhibit 2 ($3,054, e.g., for a rate of 1.50%).

When converted cash-flow series all start with the same initial amount and terminate with a single

repay- ment on the same date, as in Exhibit 2, the ac- cumulated amounts suffice as numbers indicating

preference. More generally, however, adjustments will be required to put all series on a comparable

basis - say a computation of IRR for each converted series. For Exhibit 2, IRRs are easy to compute, as

they rep- resent the growth rates required to bring the initial in- vestment of $1,500 up to the tabulated

amounts in 80 months. For the amount $5,927 corresponding to 1.50% for investment A, the required

rate, or implied IRR, is 1.73%, which may be interpreted as a sort of weighted average - of the original

IRR (2.83%) and the rate earned on reinvestment (1.50%).

The possibility of using converted series and ac- cumulated amounts was discussed by Solomon [10],

who wished to resolve the conflict between rankings based on IRR and those based on PV or NBC.

Solomon sought a procedure "that always provides a unique and correct basis for decision making." But

because accumulated amounts depend on assumed periods of accumulation and rates of return, they

hardly provide uniqueness. In Exhibit 2, for example, A ranks ahead of B if the assumed rate is 1.75% (or

more), but behind B if the rate is 1.50% (or less). As long as there is uncertainty over the proper rate of

return to assume, ranking by accumulated amount is also uncertain.

Even if Solomon's proposed use of accumulated amounts fails the test of uniqueness, it still provides

valuable insights into the conflict between IRR and PV, and it promotes comprehensiveness. Above all, it

emphasizes the importance of looking beyond the strict boundaries of the investment opportunities im-

mediately available, and of exploiting any relevant in- formation on future opportunities. Investments A

and B cannot be adequately appraised on the basis of measures like IRR and POP, which are uniquely

defined by the cash-flow series, or even measures like PV and NBC, which are defined by the same series

after discounting by an estimated cost of capital. Of the two investments, A offers relatively rapid pay-

back - clearly an advantage in the event of a near- term credit crunch, or of opportunities to make new

investments at high rates. But the rapid payback may prove embarrassing if investment opportunities

dry up or if rates of return decline in the near future; then the longer-term investment B will look

attractive because of the locked-in return. The calculation of ac- cumulated amounts may not settle the

question, posed earlier, of whether the advantages of rapid payout out- weigh the disadvantages or vice

versa, but it forces the analyst and the financial manager to face the issue. Looking ahead is desirable,

even for those with less than twenty-twenty vision.

A highly specialized application of converted cash- flow series arises in the analysis of multiple IRRs

resulting from multiple changes of sign within the original series. One way of dealing with multiple IRRs

is to convert the original cash-flow series into an alter- native form with a single change in sign, and

hence a single IRR. Grant, Ireson, and Leavenworth [8, Appendix B] illustrate a method of converting the

series by accumulating a segment of it at an assumed "auxiliary interest rate;" for perspective these

writers typically use several auxiliary rates, and permit some variation in the period of accumulation.

Another method of conversion, suggested by Solomon [10], is to discount (rather than accumulate) a

segment of the original series. But note, because these tricks are anything but unique, they do not

entirely eliminate the problem of multiple IRRs; if an analyst uses three assumed auxiliary rates for

converting a series with two IRRs, he will end up with three new series and three new IRRs. The

advantage of the procedure is not in providing uniqueness, but in providing insight.

Conclusion: Simplicity vs. Comprehensiveness

In investment analysis for capital budgeting, the opportunities to achieve comprehensiveness by using

multiple numbers to indicate preference are legion. Even though the opportunities may be distinctly

limited for single, uniquely defined cash-flow series, they become multiplied whenever the use of alter-

native cash-flow series is indicated by a need to consider alternative assumptions concerning either per-

formance or reinvestment of receipts. To suppose that any imaginative analyst or responsible financial

manager, interested in a comprehensive view, would be content to base an important appraisal and the

sub- sequent investment decision on just one of the many useful numbers available is on a par with

supposing that a hungry gourmet at a smorgasbord would be content to make a whole meal of just one

variety of pickled herring. The problem (cf. [4, p. 34]) is to select a balanced meal while avoiding

indigestion - or, put otherwise, to strike a reasonable trade-off between simplicity and

comprehensiveness.

In theory, perhaps, one might argue that an optimal trade-off between simplicity and

comprehensiveness might be determined by expanding the use of multiple numbers to the point where

marginal cost equals marginal revenue; in practice, however, such a procedure is hardly applicable

because of the difficulty of measuring the costs and benefits, both of which depend heavily on

intangibles - such as the value of information and the cost of confusion. At best, the theoretical

reference to marginal costs and benefits provides a warning that either extreme, whether pure

simplicity or total comprehensiveness, is not optimal; it invites us to strive for a happy medium, even if

we have to rely heavily on judgment in doing so.

How practitioners achieve, or try to achieve, an ap- propriate trade-off has certainly not been

determined, and at best is only roughly determinable. Question- naires suffice to determine the more

obvious rules of formal procedure, such as specification of primary and secondary techniques, but they

shed little light on informal rules and subtleties. A company's formal policy might specify, say, that IRR

was to be used as a primary number in conjunction with POP and NBC as secondary numbers, but then

not specify precisely how these three numbers were to be coordinated, or what additional numbers

(tertiary and quaternary) might be used to aid in clarifying particularly complex analyses.

Supremely elusive is the question of just how cash- flow series for actual analysis are to be chosen from

the virtually unlimited set of conceivable choices. Can the rules of choice be so precisely formulated that

a questionnaire can reliably record them? Even when formal policy limits choice to just one series, it

cannot specify precisely which series, and it cannot prevent the analysts from making an informal

analysis of several series before they finally select one for the final, formal, and official analysis. By way

of summary, multiple numbers to indicate preference are both useful and used, although the fine points

of using them are elusive. When a system for making investment decisions is simple enough to describe

unambiguously, it must be suboptimal; there are always opportunities, however concealed, to im- prove

on the system by going outside it and exploiting information not admitted by it - even if there is no

guarantee that those who try to beat the system will actually succeed. Essentially, the role of so-called

decision rules in capital budgeting is not to make the actual decisions, but to provide the decision-

makers with a point of departure from which they can start out on a difficult and uncertain journey.

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